The bank rally has largely been fueled by failing interest rates, but there's another stimulus on the way, said Joseph Battipaglia, chief investment strategist at Gruntal & Co. and managing director of the brokerage's money management division, Sterling Advisors.
That driver: a combination of the first stable interest rate environment in 20 years and bright prospects for a pickup in business activity in the next 12 months.
With bank balance sheets now rock solid and the institutions willing to lend, they are in position to profit from any increase in consumer or commercial loan demand, said Mr. Battapaglia.
How long can the bank rally run? Two more years, he said, as economic activity increases.
While he expects the bank rally to continue, not all bank or.financial services shares will rise. Gruntal likes Mercury Finance Co., Fleet Financial Group, Hubco, and tiny USBancorp.
Q.: The recent selloff in bank shares has convinced some that the bull market is over. Why don't you agree?
BATTIPAGLIA: The selloff has been exciting. Banks have been relatively strong performers. The banks in the American Banker index trade at substantial premiums to book value, so there is cause for concern.
But I believe that we haven't had a change with negative implications in the prospects for the banks. Therefore, all of this talk about lowering the prime rate and the effect on the net interest margin is overstated. On a selloff of this magnitude you can accumulate the stocks you want.
The sentiment won't last long if the fourth-quarter numbers show the resilience that I think banks have in their earnings power. I offer this as a point to ponder for the analysts who say the bank rally is over: What happens if we have a stable rate environment for quite some time, as we had in the 1960s?
I would argue that we are starting another inflection point for banks, where they are dealing with stability in interest rates and bright prospects for a pickup in economic activity.
Banks have rebuilt themselves so they can serve their role, which is to energize the economy, give it leverage, and make the money circulate. Going forward, the banks are well positioned to fuel whatever economic activity, both domestically and internationally, becomes available to them. This is a subtle inflection point, but I think the long-term implications are powerful.
Q.: Is this a rosier picture than one or two years ago?
BATTIPAGLIA: Very much so. The economy has found its basic underpinnings, and certain moribund sectors are beginning to recover. I think business activity will be better in the next 12 months than in the past 12 months. Some key sectors are showing signs of life. Recent statistics on new home sales show an improvement, for example.
The consumer, who has been slow to respond, will continue to loosen the purse strings. Industrial activity seems to be picking up. This are positive elements that will help banks.
As the banks work hard on spreading out their sources of income, there are incremental additions to their revenue that they can take advantage of that weren't there for the past couple of years. Back then, they were very busy looking at their loan losses and they were looking at cutting costs dramatically.
Banks have been aggressive in boosting their capital ratios and eliminating operations that aren't making money. That process is done. I would say right now, they are entering a new era and it is a positive situation.
I think banks can do well. The consolidation process will accelerate, which will help some regional banks. With the Japanese banks beating a retreat. money-center banks will have an opportunity after 15 years of regressing, to step into some of the more exciting places in the world. where there is dynamic growth. like Southeast Asia and Latin America.
Q.: Isn't there a flip side to your view, or some worries?
BATTIPAGLIA: If you look at a bank balance sheets, there's a preponderance of Treasuries sitting on the balance sheet, versus loans to strip malls in the middle of Florida. You have to say the banks are rock solid. They certainly aren't going on a lending spree as they did in the 1980s, when you had junior people making loans.
Commercial banks recognized what the Fed did with rates to save their bacon, and they have been very deliberate about how they spend money.
The acquisitions they are making aren't meant to excite Wall Street by being bigger than the previous one, but rather because the deal fits into their business strategy.
The overriding negative would be if we entered a period of deflation, in which the economy would turn in on itself. We would have negative growth rates and that would hurt banks. Although rates would fall, the level of business activity would fall, too, and stock valuations would contract.
Right now, I don't see any negatives I would dwell on.
Q.: The bull market is three years old, though. Shouldn't it be running out of breath?
BATTIPAGLIA: I don't think you can say with any certainty that any market you are talking about is enough already. The first part of the rally was the big rate falloff and that was quite a ride. Since the banking industry is in a state of positive change, the rally can extend, because we are in a different set of circumstances.
Will the rally continue to be as dynamic? Probably not. Will we have better returns there than in alternatives? Yes. Will this group perform among the best in the S&P? I would say that's so.
Certainly, I see the rally continuing for the next two to three years. The relative strength of the emerging economy will carry it.
Q.: But low interest rates won't last forever. When they change, won't that hurt banks?
BATTIPAGLIA: You have to look at rates in terms of the net interest margin. At 6% interest rates, banks are much more profitable than at 8% or 10% interest rates. We don't know where inflation will be in 12 months. We all say we do, but we don't.
We can guess where the economy will be in 12 months. If you look at things right now, the spreads are very wide. It gives banks incredible leverage in this environment to exploit those spreads.
The spreads can be maintained through some clever financial management. That is a good opportunity for the banks, because they can work on the loan side of their business without having to worry too much about fluctuations in spreads.
If inflation stays relatively stable, the banks have a better chance to make each piece of the business they write profitable. That's the opportunity.
A good example of that is Mercury Finance, one of the stocks we like. Mercury makes used car loans. The marketplace for used cars is very strong right now. By extension, that business should be vibrant, and it shows up in the company's results.
Q.: Aren't the stock valuations fairly high? And there don't seem to be any positive earnings surprises to move them higher.
BATTIPAGLIA: I think you are at a point now where you can't make blanket statements about groups. In 1991 and 1992, sector investing made a lot of sense. As a matter of fact, index investing made a lot of sense. You had a rising tide of valuations almost across the board. courtesy of dramatic shifts in macroeconomic factors such as interest rates.
Now you are at the point where you have to look beneath the aggregates of the sector and see what's going on.
If you accept my thesis that the economic environment and the bank's position in it is a good one, then you just go the through the range of banks from large to small and see who has it going in the right direction and who doesn't.
I would argue that companies like Mercury Finance, which enjoys a particular niche in the marketplace, has a lot more room to run. It's not in all states and the used car values are going up relative to new car prices so the loan activity is there. They would benefit.
The there's the regional banks. They are out on the prowl on a regular basis, buying banks for maybe 1.75 to 2 times book value to supplement their territories. Fleet Financial. which we like is one of those. Hubco. another pick, is more likely a target.
Granted, some banks reflect that premium. UJB Financial is supposed to be bought about 100 times already. How much more is going to be in that stock? But there are other ones that don't draw that much attention.
USBancorp in Pennsylvania, for example, which trades at 9% over book value. It would fit into PNC's system or First Fidelity's system. There's more value to be had there.
Then there are the money-center banks. If you look at Citicorp, don't look at their domestic operations, look at their overseas operations.
I think this reversal of the Japanese is a major changing point in the relative positioning of money-center banks that will be exploited by a Citicorp in the future. And that hasn't been there for 15 years. I see American banks becoming the stronger banks for a change.